I '

I Taking. Risk
Will derivatives cause a major blowup in
the world's credit markets?

N MAY 10, GLOBAL FI- derivatives ifinvestors all tried to "mfor

0
nancial markets reeled the evit at the same time." Even Federal
as rumors spread that Reserve Chairman Alan Greenspan, long
one or more hedge a fan of derivatives because they spread
funds had such big loss- risk around the financial system, is start-
es on General Motors ing to sound concerned. In a speech to
Corp. stock and debt Chicago bankers the day the auto giants'
that die! inlight collapse. Although it was- paper was downgraded, he said that some
n't cie;o- that was imminent, it's sure that investors could face "unanticipated loss-
any funds that had bet lately against GM es" because "the rapid proliferation of de-
stockwhile also piling up on i~ debt-a fa- rivatives products inevitably means that historically hcen the case." sa!.s Peter 1 .
vorite hedge-fund play-would have been some will not have been adequately tested Petas, founder ofresearchcr Creditsights
caught in a double whammy. On May 4, by market stress." Inc. in New l h r k
GM stock soared when billionaire Kirk Anxiety is high: Big losses in credit de- The purpose of credit derivatives is to
Kerkorian offered to buy 5% more of the rivatives could set off a chain reaction. enable banks to transfer to a broader
equity for $870 million. The next day, the Banks, insurers, and bond and pension market the risk of defaults on corporate
value of GM'S bonds plummeted after rat- funds, as well as hedge funds, are inch- debt they've issued. No bonds or loans ac-
inas agenq Sr.~ndard c ~ b l ? linked as is- tually change hands. Instead, a credit de-
& l'mr'~.downgraded quers, htlyers, and rivatives dealer, usually anotherbank or a
53-5 mill~on ~ t cnf ' traders. h n ;~rlparentlv Wall Street h, agrees to take on the risk
of a default in exchanee for a e.rice..rather
~ ~

and Ford Motor Co. .",'!1'!?!?J(n&?,!i__.~-~~ minor problem, such

"
nerapid frrr series 8 ' NOTIONAL VALUE OF
debt to junk.
I as a k n y of down-
grades, could quickly
l i e an insurance policy. The dealer can 5
also pass along the risk by bundling 100 $
of events raised the engulf the fmancial or more credits, fmm top investment 2
!I
specter that high- system by sending grade to junk, to create what's called a ::
' stakes-and highly markets into a tail- synthetic collateralized debt obligation
! leveraged-bets on the spin, wiping out (CDO). After slicing the cDo into tranch- 2
I creditworthiness of -' - hedge funds, and es ofiring higher income for taking on 2
I,,
1, companies could bring 1 , tj oit -. dragging down banks greater risk, he sells them to large in- Z
zlobal debt markets to ,at < w di ~~ ~~ ~ ~hrin
~ ~ . ~ t that
~ ~ lent
e them
~ money. vestors such as hedae funds.. . ~ensions, k
their knees. The expllo- If that sounds l i e a and endowments. $
- ,
s i x growth of credit derivatives-financial rtplay 3f the Long-Tenn Capital Manage- ..
conmcts whose value is based on corpo- ment hedge-fund meltdown, it is, only A DERIVATIVES TSUNAMI? g
rate bonds and loans-is cenaal to these worse. In 1998, LTcM borrowed about CDOs ARE THE CASINO of choice for in-
worries. The market mpled in value to 100 times its capital to hold derivatives vestors seeldng high yields from bonds. : ,
$ 8 5 billion last year and is still growing worth some $1.25 nillion, or 1,000 times The lure: Investors don't actually have to 2
exponentially. Investing legend Warren E. the find's capital. Today, hedge funds are pony up any hard cash. They usually have *
Butfett long ago labeled derivatives as art 181dusuy with $1 trillion in assets, to produce just enough collateral to show
"weapons of mass desrmction." more than three times the size it was then they can cover any losses. "Iis a trade on $
Now the monetary autholities are get- and trade newfangled derivatives that are a company's creditworthiness," says 2
ting rattled, too. The International Mone- vastly more opaque and risky. "There's James M. Ballentine Ill, managing duet- :
tary Fund warned in its Apr. 6 annual re- more borrowing by hedge funds in an tor at Lehman Brothers Inc. in Nen York. 5
port of a possible meltdown in credit untested, illiquid credit market than has So far, C D o players have surfed the =

96 i BusinossWeek I May 232OC5

 'Oilc or m o drfiulis c:in hc cubed-or derivatives that invest in de
very destructive." rivatives of derivatives. Such an invest-
Investors smell trouble ment is three times removed fiom any
ahead. Since January, outflows bond or loan-and far harder to under-
# ~.
i From junk-bond funds have to- stand and price. Thomas Finucane, finan-
i taled $6.9 billion, while low- cial stock fund manager with Boston's
grade companies are strug- John Hancock Funds LLC, calls them "de-
\, gling to borrow money. The rivatives on steroids." Inevitably, he says,
shift in sentiment is enough to some bankwill "lend to x ~ Hedgez Fund
depress bond prices-with the on one of these funky derivatives, the
added leverage of derivatives tbimg will unwind, and then it's tap city."
intensifying any move. Says Banks, often the last line of defense, "will
Mark H. Adelson, smctured fi- have to eat the loss," he says.
nance research director at No-
:] mura Securities International EXTENDING THE BETS
4 Inc.: "These products magnify IF THAT'S THE CASE, derivatives
&-
1 4&%m
exposure to adverse changes. wouldn't have spread credit risk
When things deteriorate and throughout the financial system as advo-
1 defaults go up, the conse- cates claim. Some analysts fear credit
1i quences can be even worse." risk is, in fact, concentrated among the
{ Already, the credit-deriva- five largest U.S. banks. They not only is-
tives market is taking hits. The sue new derivatives contracts and trade
'1
! cost of insuring investment- them but also are the ultimate insurers
ri 1 grade debt against default is hacking them. Studies by bank regula-
.d
. . , ,
,
rising sharply. The Dow Jones tors and rating agencies have found
i c D X North American Invest- banks aren't using these instruments as
ment Grade index-which risk-management tools, but rather as
measures the price of so-called profit machines. Creditsights' Petas says
credit default swaps-is up investment banks are trading derivatives
18%since May 3. On May 10 like mad, making investments in hedge

. - alone, the cost of protecting a funds that buy derivatives, and then
bilge W:IYC in glolx~lcredit rn:~rkerssuc- ! i l O l l million investment in top-quality lending money to funds so they can ex-
crssfull.: Thar could change quuickl? ;.\ paper spiked more than l2%, to tend their bets in the credit market. Any
sharp uptick in interest rates might push $710,000, according to derivatives broker unraveling of CDOS "has the potential to
some companies to the wdl. Surprises GFI Group. The same day, S&P down- be extremely messy," he says. "There's
similar to Enron and WorldCom-large, graded several synthetic CDO portfolios just no way to measure what's at stake."
investment-grade companies that fall built by Deutsche Bank and warned otb- If things do go awry, the ripples may
From grace overnight-could roil mar- ers could follow. Earlier, Moody's In- spread worldwide. Derivative demand
kets. What's more, the number of bonds vestors Services downgraded 11 deals, has been as profound in Europe among
I rated at just one notch above default has from other intermediaries tied to bonds of investors seeking high income From syn-
doubled in two years, pointing to an im- American International Group the insur- thetic CDOs d ~ aare t top-rated by S&P and
pending spike in defaults, according to er being probed by regulators. other agencies. Even so, two European
1 3 s&P. "It doesn't need a 20% default rate Downgrades could have a disastrous banks have already sued BankofAmerica
I C across the corporate universe" to set off effect on the latest flavors o f c ~ o sAs . de- and Barclays Capital over how these in-
a selling spree, says Anton Pil, head of mand soared, Wall Street created ever- suuments were sold and priced. New
t $
' 2 ! fixed income at JPMorgan Private Bank. more-compleuvarieties. The latest: CDos rules that require European investors to
put derivative contracts on their books at
market value could trigger an exodus if
there are losses. When asked about the
bank. enters into a credit defaultswap in which an most likely source of tbe next corporate
irlsurance company, pension fund, hedge fund, or
Y
The $8.5 trillio n market
other investor assumes the risl( o f an outri ght default
in return for a payment.
crisis, one high-ranking European regu-
lator replied: "Derivatives."
in credit deriviitives-
. -.
- - Derivatives are not inherently toxic.
~

financial contracts whose 2 The dealer can also create asynthetic r;U-U^by One senior Wall Streeter compares them
bundling theswapsof 100or more loar1s and bond8 , to fertilizer: "It can help your garden
value is based on loans ' toeether in one oortfolio. crow or can be made into bombs." To
and bonds-tripled in size - plenty of worried critics, the benign in-
3
.
The portfol~o1s then sliced into differen, ,,,. gredient of bountiful liquidity can quick-
lastyear.The hottest . "
with various .
levels of r~sk,.frorn
' '
top -
lnve
products are synthetic ly become explosive when mixed-as
'grade on down to junk, now-with a lack of nansparency, poor
-~
collateralized debt riskmanagement, and excessive hype.
obligations, or rnn= 4 The individual tranchesaresold as bondsioinvesrors,

- usually hedge and pensionfunds. The riskiesttranches -By Mara Der Hovanesian, with
Hen:5 how the p ~ higher
y income, but are mostvulnerable to losses. Chester Dawson in New York and
with Keny Cnpell in London